The Effects of Business Environments on Development

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Policy Research Working Paper 5402, In the past decade the World Bank has promoted and complementary institutions Some elements of the. improving business environments as a key strategy for business environment such as labor flexibility low entry. development which has resulted in a significant amount and exit barriers and a reasonable protection from the. of investment in collecting firm level investment climate grabbing hands of the government seem to matter a. surveys across countries What lessons have emerged from great deal for most economies Other elements such as. the papers using these new data The key finding is that infrastructure and contracting institutions courts and. the effects of business environments are heterogeneous access to finance hinge on their initial status and the size. and depend crucially on industry initial conditions of the market. This paper a product of the Finance and Private Sector Development Team Development Research Group is part of a. larger effort in the department to understand the role of business environments in development Policy Research Working. Papers are also posted on the Web at http econ worldbank org The author may be contacted at lxu1 worldbank org. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development. issues An objective of the series is to get the findings out quickly even if the presentations are less than fully polished The papers carry the. names of the authors and should be cited accordingly The findings interpretations and conclusions expressed in this paper are entirely those. of the authors They do not necessarily represent the views of the International Bank for Reconstruction and Development World Bank and. its affiliated organizations or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team, The Effects of Business Environments on Development. Surveying New Firm Level Evidence1,Lixin Colin Xu,World Bank. I am grateful to Manny Jimenez Mohammad Amin Robert Cull Ann Harrison Guofang Huang Justin Lin Rita. Ramalho Yan Wang and especially three anonymous referees for helpful discussions comments and suggestions. The opinions expressed here are the author s alone and do not implicate the World Bank its executive directors or. the countries that it represents,1 Introduction, Recently policy makers and multinational organizations have increasingly focused on a. sound investment environment as a strategy for economic development Stern 2002 World Bank. 2005 It is difficult to define investment climate or business environment precisely 2 but Stern. 2002 notes that it is the policy institutional and behavioral environment both present and. expected that influences the returns and risks associated with investment in a specific location In. other words the business environment covers whatever external environment that affects the returns. and risks faced by investors This general definition includes three broad categories 3 The first. category covers macroeconomic aspects such as fiscal monetary and exchange rate policies which. clearly affects investors returns high tax rates for example would lower return while inflation. would increase variability of returns The second category includes governance institutions and. political stability Take for instance rule of law which affects investors decisions about how much. to invest and what organizational form to take Institutions also include informal ones such as the. general level of trust social capital and social network Knack and Keefer 1997 North 1990 Shirley. 2008 Zak and Knack 2001 which would facilitate new transaction relationships and therefore firm. expansion The final category includes infrastructure necessary for productive investment such as. transportation electricity and communications This paper discusses the effects of the second and. third categories of the business environment which include government policies and behaviors. related to the provision of infrastructure tax burdens protection of property rights labor and entry. regulations World Bank 2005, Identifying the effects of the business environment is difficult The first difficulty concerns.
measurement problems e g eliciting truthful responses about corruption For a long time the. available data are only at the country level Since multicollinearity about various aspects of the. business environment is particularly severe at the country level for instance among the commonly. used cross country ICRG governance indicators the correlation coefficient between the rule of law. and the control of corruption is 0 62 between 1996 to 2007 identifying the business environment. effects at the cross country level becomes particularly difficult This shortcoming can be partially. overcome with firm level data which often allow us to go further than cross country and cross. industry data 4 Of great help are vast variations within a country The average tax burden in inland. The terms investment climate and business environment are used interchangeably in this paper. Other features such as geography and weather also belong but since little can be done to alter them their effects. are not discussed in this paper, The touting of micro data here should not be interpreted as discriminating against studies based on sector or. country level data which are complementary to those on firm level data Some key explanatory variables differ only. Chinese provinces for instance is twice that of coastal areas Cai et al 2011 To understand the. effects of tax burden on firm performance one must take advantage of within country variations. which holds the legal system and therefore de jure institutions constant 5 Moreover some key. measures of a country can only be obtained with firm level data Bigsten and Soderbom 2006 For. example researchers have often used dispersion of productivity within an industry of a country to. capture industry level competition which can be constructed only by exploiting firm level data And. to understand what types of firms are credit constrained or particularly vulnerable to government. expropriation only firm level data can be relied on Unfortunately very little comparable firm level. data were available in developing countries until now. The past 10 years has witnessed an explosion of firm level evidence on the effects of. business environments an explosion partly due to the data efforts of the World Bank mainly the. World Bank Enterprise Surveys also known as the Investment Climate Surveys These data efforts. lead to consistent measures of business environments which in turn usher in a substantial new. literature on how business environments affect development at the firm level To push the research. forward it is helpful to review what lessons have been learned. In this paper I survey evidence on how business environments affect economic development. Given the vastness of this task one has to be selective Thus I focus on firm level research related to. the World Bank Investment Climate Surveys with occasional discussions of outside firm level. research that are particularly relevant about the effects of business environments This would. automatically leave out studies based on the complementary Doing Business Survey A benefit of. this omission is that we can focus only on de facto institutions or regulations in the case of. Investment Climate Surveys while ignoring new issues related to de jure institutions or regulations. in the case of Doing Business Surveys Hallward Dreimier et al 2010 Several topics are too. broad to cover but there are excellent surveys already and not much is lost in skipping them The. at the macro level in which case it is only natural to rely on such data for identification Often studies based on. macro data are useful first steps in our quest for understanding a specific topic For instance Knack and Keefer. 1995 1997 rely on macro indicators to show the potential importance of institutions and social capital which then. usher in numerous micro studies to examine the issues more closely. Note that while the de jure institutions are held constant within a country the de facto enforcements of institutions. across regions are not Hallward Dreimer et al 2010 Only to the extent that de jure institutions capture a. significant source of variations for de facto institutions relying on within country variations mitigate the omitted. variable bias due to the lack of control for institutions. skipped topics include the effects of large scale privatization the effects of reforms in access to. finance and corporate governance 6, Almost all investment climate surveys are cross sectional in nature with the notable. exception of BEEPS in Eastern Europe and in a few countries such as India However since. institutions and investment climates change slowly the attempt to identify effects of investment. climate relying on within country across time variations in a short time span is unlikely to go far. Griliches and Hausman 1986 Not surprisingly I am unaware of solid firm level empirical studies. using panel investment climate surveys so far, The most common mode of identification with cross sectional firm level data is to construct. proxies of the local or national business environment by using city or country level measure of. access to finance tax burden corruption labor flexibility and so on and then relate them to firm. performance In the case of country level measures of business environments multiple country data. have to be used A variety of robustness checks are often used to ensure the robustness of the key. findings Often omitted city level or country level proxies such as level of development and other. aggregate level variables are added to check the robustness of the results Cai et al 2011. Alternatively instruments for key business environment measures are used An example is to use the. distance to surrounding enforcement offices to instrument the enforcement of regulations Almeida. and Carneiro 2009 Another common method of identification in this literature is the difference in. difference approach using cross country cross industry data in which the more disaggregated. outcomes are regressed toward country dummies industry dummies and an interaction term of. country level treatment with industry level sensitivity variable 7 The idea is that more sensitive. industries should be more affected by the treatment By controlling for country and industry dummies. all country and industry specific factors are controlled for which makes this method more. convincing and less subject to the omitted variable bias than most other cross sectional estimations. If the interaction term proves to be significant then more sensitive industries are indeed responding. as predicted to the treatment supporting the notion of causality from the treatment to the outcome. especially for the sensitive type Often sensitivity checks are applied in which more interaction. terms of the treatment with other industry level variables are used to make sure that it is indeed. See La Porta et al 2000 Levine 1997 World Bank 2001 and 2008a Djkankov and Murrell 2002 and. Megginson and Netter 2001 We also do not discuss the lessons from survey methodology If interested see. Recanatini et al 2002 and Iarossi 2006, For the use of difference in difference approach in the business environment literature see Ciccone and. Papaioannou 2007 Aghion et al 2008 and Klapper et al 2006. the sensitivity variables rather than the robust check variables that cause the original interaction. term to be statistically significant, Given the cross sectional nature of the investigations and questionable validity of exclusion.
restrictions needed to construct instrumental variables most research using the investment climate. data cannot establish causality convincingly Invariably the estimations suffer from reverse causality. omitted variable bias and other issues The results should therefore be interpreted as a collection of. correlations To the extent that the results are robust across similar contexts or can be coherently. interpreted by plausible theories the conclusions from the results are more credible. Since the conclusions related to the effects of the business environment for each individual. study have to be tentative it is even more imperative to summarize existing evidence and seek a. coherent storyline to tie them together As the reader shall see the body of correlations gathered from. the studies does point to a plausible story the effects of the business environment vary across. industry complementary institutions and initial conditions Some elements of the business. environment turn out to loom large in most economies such as a basic protection of property rights. against government expropriation labor flexibility and low entry and exit barriers which are found. invariably to be important in explaining economic performance in various economic contexts Other. elements such as infrastructure and contracting institutions hinge critically on initial conditions. Infrastructure for instance is found to matter much more in countries with a low initial stock of. infrastructure while the quality of courts and access to finance are more important in richer countries. Country specific development bottlenecks may also be important for understanding why some. countries are under developed,The rest of the paper wi. The Effects of Business Environments on Development the effects of business environments sound investment environment as a strategy for economic

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